 The process of identifying and evaluating capital

projects, this is, projects where the cash flow to the firm
will be received over a period longer than a year.
 Any corporate decisions with an impact on future
earnings can be examined using this framework.
 Decisions about whether to buy a new machine, expand
business in another geographic area, move the corporate
headquarters or replace a delivery truck, to name a few,
can be examined using a capital budgeting analysis.
 Often involves the purchase of costly long-term
assets with lives of many years, the decisions
made by determine the future success of the firm.
 The principles underlying the capital budgeting
process also apply to other corporate decisions,
such as working capital management and making
strategic mergers and acquisitions.
 Four administrative steps:
› Idea Generation
› Analyzing Project Proposals
› Create the Firm-wide Capital Budgeting
› Monitoring Decisions and Conducting a Post-Audit.
 Replacement project
 Replacement project for cost reduction
 Expansion projects
 New product or market development
 Mandatory projects
 Other projects
 Decisions are based on cash flows.
 Timings of cash flows is crucial.
 Cash flows are based on opportunity costs.
 Cash flows are analyzed on an after-tax basis.
 Financing costs are ignored.
Decisions are based on cash flows, not accounting
income: The relevant cash flows to consider as part
of the capital budgeting process are incremental
cash flows, the changes in cash flows that will occur
if the project is undertaken.
› Sunk cost
› Externalities
› Conventional / unconventional cash flow pattern
 Sunk Cost:
› Cost that cannot be avoided, even if the project is
undertaken.
› These costs are not affected by the accept/reject
decision, they should not be included in the analysis.
 Externalities:
› Are the effects the acceptance of a project may have
on other firm cash flows.
› The primary one is a negative externality called
cannibalization, which occurs when a new project
takes sales from an existing product.
› When considering externalities, the full implication of
the new project(loss on sales of existing products)
should be taken into account.
 Conventional Cash Flow Pattern: If the sign on
the cash flows changes only once, with one or
more cash outflows followed by one or more
cash inflows.
 An Unconventional Cash Flow Pattern: has
more than one sign change.
2. Cash Flows are based on Opportunity Costs:
Cash flows that a firm will lose by undertaking
the project under analysis.
For example, when building a plant, even if the
firm already owns the land, the cost of the land
should be charged to the project because it could
be sold if not used.
3. The Timing of Cash Flows is Important:
Capital budgeting decisions account for the time
value of money, which means that cash flows
received earlier are worth more than cash flows
to be received later.
4. Cash flows are analyzed on an after-tax basis:
The impact of taxes must considered when
analyzing all capital budgeting projects. Firm
value is based on cash flows they get to keep, not
those they send to the government.
5. Financing Cost are reflected in the Project’s
Required Rate of Return:
Do not consider financing costs specific to the
project when estimating incremental cash flows. The
discount rate used in the capital budgeting analysis
takes account of the firm’s cost of capital. Only
projects that are expected to return more than the
cost of the capital needed to fund them will increase
the value of the firm.
 Independent projects are projects that are
unrelated to each other and allow for each project
to be evaluated based on its own profitability.
 Mutually exclusive means that only one project
in a set of possible projects can be accepted and
that the projects compete with each other.
 If a firm has unlimited access to capital, the firm can
undertaken all projects with expected returns that
exceed the cost of capital. Many firms have
constraints on the amount of capital they can raise
and must use capital rationing. If a firm’s profitable
project opportunities exceed the amount of funds
available, the firm must ration, or prioritize, its
capital expenditures with the goal of achieving the
maximum increase in value for shareholders given
its available capital.
Year Project A Project B
0 -$2000 -$2,000
1 1,000 200
2 800 600
3 600 800
4 200 1,200
 A project’s NPV profile is the graph that shows a
project’s NPV for different discount rates.
 The discount rate at which NPVs of the projects
are equal is called crossover rate.
 20x1 20x2 20x3 20x4
Project A -550 150 300 450
Project B -300 50 200 300

What is the crossover rate of project A and B?

The crossover rate is the discount rate that makes the NPVs of
Projects A and B equals. That is, it makes the NPV of the
differences between the two projects’ cash flows equal zero.
To determine the crossover rate, subtract the cash flows of
Project B from those of Project A and calculate the IRR of the
differences.
 A key advantage of NPV is that it is a direct
measure of the expected increase in the value of
the firm. NPV is theoretically the best method. Its
main weakness is that is does not include any
consideration of the size of the project. For
example, an NPV of $100 is great for a project
costing $100 but not so great for a project costing
$1 million.
 A key advantage of IRR is that is measures
profitability as a percentage, showing the return on
each dollar invested. The IRR provides information
of the margin of safety that the NPV does not. For
the IRR, we can tell how much below the IRR
(estimated return) the actual project return could fall,
in percentage terms, before the project becomes
uneconomic (has a negative NPV).
 The disadvantages of the IRR method are (1) the
possibility of producing rankings of mutually
exclusive projects different from those from NPV
analysis and (2) the possibility that a project has
multiple IRRs or no IRR.
Year Project X Project Y
0 -2000 -2000
1 500 0
2 500 0
3 500 0
4 500 0
5 500 4,000
NPV 895 1,484
IRR 41% 32%
 Year 1: $3,000
 Year 2: $2,000
 Year 3: $2,000
› What is the project’s payback period?
› What is the project’s discounted payback period?
› What is the project’s NPV and IRR?
› What is the project’s profitability index?
 Cash Flows
Year Project A Project B Project C Project D Project E Project F
0 -1000 -1000 -1000 -1000 -1000 -1000
1 1000 100 400 500 400 500
2 200 300 500 400 500
3 300 200 500 400 10000
4 400 100 400
5 500 500 400
Payback 1 4 4 2 2.5 2
NPV -90.91 65.26 140.6 243.43 516.31 7380.92
Comment on why the payback period provides misleading information
about the following: 1. Project A. 2. Project B vs Project C. 3. Project D vs
Project E. 4. Project D vs Project F.
 Cash Flows
Year Project A Project B Project C Project D Project E Project F
0 -1000 -1000 -1000 -1000 -1000 -1000
1 1000 100 400 500 400 500
2 200 300 500 400 500
3 300 200 500 400 10000
4 400 100 400
5 500 500 400
Payback 1 4 4 2 2.5 2
NPV -90.91 65.26 140.6 243.43 516.31 7380.92

Project A does indeed pay itself back in one year.

However; this result is misleading because the
investment is unprofitable, with a negative NPV.
 Cash Flows
Year Project A Project B Project C Project D Project E Project F
0 -1000 -1000 -1000 -1000 -1000 -1000
1 1000 100 400 500 400 500
2 200 300 500 400 500
3 300 200 500 400 10000
4 400 100 400
5 500 500 400
Payback 1 4 4 2 2.5 2
NPV -90.91 65.26 140.6 243.43 516.31 7380.92

Although projects B and C have the same payback

period and the same cash flow after the payback
period, the payback period does not detect the fact
that Project C’s cash flows within the payback
period occur earlier and result in a higher NPV.
 Cash Flows
Year Project A Project B Project C Project D Project E Project F
0 -1000 -1000 -1000 -1000 -1000 -1000
1 1000 100 400 500 400 500
2 200 300 500 400 500
3 300 200 500 400 10000
4 400 100 400
5 500 500 400
Payback 1 4 4 2 2.5 2
NPV -90.91 65.26 140.6 243.43 516.31 7380.92

Project D and E illustrate a common situation. The

project with the shorter payback period is the less
profitable project. Project E has a longer payback
and higher NPV.
 Cash Flows
Year Project A Project B Project C Project D Project E Project F
0 -1000 -1000 -1000 -1000 -1000 -1000
1 1000 100 400 500 400 500
2 200 300 500 400 500
3 300 200 500 400 10000
4 400 100 400
5 500 500 400
Payback 1 4 4 2 2.5 2
NPV -90.91 65.26 140.6 243.43 516.31 7380.92

Project D and F illustrate an important flow of the

payback period – that the payback period ignores
cash flows after the payback period is reached. In
this case, Project F has a much higher cash flow in
Year 3, but the payback period does not recognize
its value.
 The Dawn Co. is considering the purchase of new machines in order to expand
their business. The machines have a useful life of five years. The required rate of
return for the expansion is 17%. The company’s tax rate is 40%.
Purchase price of new machines $450,000
Installation charges $ 50,000
Increased revenues from expansion $200,000/year before taxes
Salvage value at the end of the fifth year $175,000.
› What is the cash outflow at t = 0?
› What are the depreciation deductions if the machines fall in the MACRS five-
year class?
› What is the book value of the machines at the end of year five?
› What is the taxable gain/loss from the sale of the machines at the end of the
useful life if they are sold for the estimated salvage value?
› What is the tax on the sale of the machines at the end of year five ?
› What is the terminal year non-operating cash flow (cash proceeds from the
sale)?
 As a financial analyst, you must evaluate a proposed
project to produce printer cartridges. The equipment
would cost $55,000, plus $10,000 for installation. Annual
sales would be 4,000 units at a price of $50 per cartridge,
and the project’s life would be 3 years. Current assets
would increase by $5,000 and payables by $3,000. At the
end of 3 years the equipment could be sold for $10,000.
Depreciation would be based on the MACRS 3-year class,
so the applicable rates would be 33, 45, 15, and 7 percent.
Variable costs would be 70 percent of sales revenues, fixed
costs excluding depreciation would be $30,000 per year,
the marginal tax rate is 40 percent, and the corporate
WACC is 11 percent.
Truman Industries is considering an expansion.
The necessary equipment would be purchased for
$9 million, and it would also require an additional
$3 million investment in working capital. The tax
rate is 40 percent.
a)What is the initial investment outlay?
b)The company spent and expensed $50,000 on
research related to the project last year.
Would this change your answer? Explain.
c)The company plans to use a building it owns but
is not now using to house the project. The building
could be sold for $1 million after taxes and real
estate commissions. How would that affect your
answer?
Eisenhower Communications is trying to estimate the first-
year net operating cash flow (at Year 1) for a proposed
project. The financial staff has collected the following
information on the project:
Sales revenues $10 million
Operating costs (excluding depreciation) 7 million
Depreciation 2 million
Interest expense 2 million
The company has a 40 percent tax rate, and its WACC is
10 percent.
a)What is the project’s operating cash flow for the first year
(t 1)?
b)If this project would cannibalize other projects by $1
million of cash flow before taxes per year, how would this
change your answer to part a?
c)Ignore part b. If the tax rate dropped to 30 percent, how
would that change your answer to part a?
Kennedy Air Services is now in the final year of a
project. The equipment originally cost $20 million,
of which 80 percent has been depreciated.
Kennedy can sell the used equipment today for $5
million, and its tax rate is 40 percent. What is the
equipment’s after-tax net salvage value?
You must evaluate a proposed spectrometer for the R&D
department. The base price is $140,000, and it would cost
another $30,000 to modify the equipment for special use by the
firm. The equipment falls into the MACRS 3-year class and would
be sold after 3 years for $60,000. The applicable depreciation
rates are 33, 45, 15, and 7 percent as discussed in Appendix 12A.
The equipment would require an $8,000 increase in working
capital (spare parts inventory). The project would have no effect
on revenues, but it should save the firm $50,000 per year before-
tax labor costs. The firm’s marginal federal-plus-state tax rate is
40 percent.
a. What is the net cost of the spectrometer, that is, what is the
Year 0 project cash flow?
b. What are the net operating cash flows in Years 1, 2, and 3?
c. What is the terminal cash flow?
d. If the WACC is 12 percent, should the spectrometer be
purchased?